Opinion: How can I get rid of an annuity while staying in my current tax bracket?

Q.: Dan, my recent non-qualified annuity statement shows an opening value of $100,161.67, purchase payments since 6/2010 of $117,374.92 and a cash surrender value of $203,781.44 . I want to get rid of this pension but stay in the current 24% tax bracket. How can I accomplish this? What are my options? No suggestions?

Thanks for your help on this,


A.: Mary, the key figure for assessing tax liability is the “base”, which is basically the after-tax money in the account. Although they are often the same, the basis may be different from that of “purchase payments”. The fact that this contract has a purchase payment amount that isn’t a pretty round number makes me suspect that the basis may be different. The annuity company should have basic information, but if it doesn’t, there are ways to track it down.

You have many options for getting rid of the annuity, but today I will only cover a few of the most common ones selected.

First, a brief explanation of the taxation of distributions from a non-qualified annuity is in order.

To keep the numbers easy to follow, let’s say the base is $50,000 and the value is $200,000. This means that $50,000 was taxed before it was deposited into the account and will be non-taxable when withdrawn. The other $150,000 is revenue. If you simply surrender the policy, you will receive a check for $200,000 with $150,000 of income taxed as ordinary income.

If you only withdraw $25,000 to stay in your target tax bracket, the entire $25,000 is considered income and is taxable. You would then have a $175,000 contract with the same base of $50,000. Any withdrawal you make is still considered a win until there is no longer a win in the contract. At that time, the base can go out and is not taxed.

So if $25,000 was the amount that kept your income at the desired level, it would take you 6 years to distribute all the income, assuming the contract neither gained nor lost value during that time.

If you withdraw the funds over time, one option to consider if you don’t like the contract you have is to transfer the funds to a new annuity via a “1035 exchange”. You do not incur any tax on such an exchange. An exchange won’t solve your tax problem or change the basis, but it might help if you don’t like the current product.

You should be aware of the surrender charge on the current contract and on any new contract if you are switching. Twenty years ago, most annuities had high surrender charges that applied for many years. Many contracts these days have no surrender charge and are very inexpensive.

There aren’t many ways to get around taxes. You could pass the taxes on your death to someone else by naming them beneficiary. The obvious disadvantages of this are that you have to die for the money to be transferred to them and you cannot use the funds in the meantime. However, for some it is OK because they don’t need the money to live and they leave the money to someone in a lower tax bracket or to a charity (tax bracket zero). It is not possible to give away the income directly during your lifetime without the income first becoming taxable income for you.

You could exchange this annuity for a combined annuity/long-term care product. This will make the income non-taxable if used for certain long-term care expenses. An obvious downside here is that you have to decline to the point of needing this type of care. However, if paying for long-term care is a concern, this sum of money could be used as a reserve to cover these costs. You shouldn’t expect these combined annuities to increase much in value due to the costs of the underlying LTC insurance built into the contract. Annuity contracts can be complex, so it’s important to work with a specialist.

Finally, you can “pay off” the contract. It’s basically changing the contract from a pot of money to a contracted revenue stream for a set period of time or your lifetime. This will not avoid taxes but will spread the taxable income over a longer period. I run a long time so I’ll save more explanations about the annuity for another time.

If you have a question for Dan, please. send him an e-mail with “MarketWatch Q&A” on the subject line.

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving customers nationwide from offices in Orlando, Melbourne and Tampa Florida. His comments are for informational purposes only and cannot replace personalized advice. Consult your advisor to find out what is best for you. Some questions from readers are edited to facilitate the presentation of the topic.

Comments are closed.